Audit test 4

74 Under which of the following circumstances would an entity be expected to accrue a loss contingency for the period under audit? A. The entity estimated the amount of a claim with a probable adverse outcome before issuance of the audit report. B. The entity recorded the amount of an asset impaired as of the balance sheet date. C. A reasonable estimate was determined for a liability incurred after the balance sheet date. D. Legal counsel communicated that an unfavorable judgment from current litigation was reasonably possible.

Answer (A) is correct. A loss contingency is an existing condition, situation, or set of circumstances involving uncertainty as to possible loss that ultimately will be resolved when one or more future events occur or do not occur. A material contingent loss must be accrued (debit loss, credit liability or asset valuation allowance) when two conditions are met. Based on information available prior to the issuance (or availability for issuance) of the financial statements (and therefore the auditor's report issued with the statements), accrual is required if (1) it is probable that, at a balance sheet date, an asset has been impaired or a liability has been incurred and (2) the amount of the loss can be reasonably estimated.

53 Which of the following matters will an auditor most likely communicate to those charged with governance? A. The effects of significant accounting policies adopted by management in emerging areas for which no authoritative guidance exists. B. A list of negative trends that may lead to working capital deficiencies and adverse financial ratios. C. Difficulties encountered in achieving a satisfactory response rate from the entity's customers in confirming accounts receivables. D. The level of responsibility assumed by management for the preparation of the financial statements.

Answer (A) is correct. AU-C 260, The Auditor's Communication with Those Charged with Governance, requires the auditor to inform those charged with governance about his or her views on qualitative aspects of significant accounting practices. These include the initial selection of, and changes in, significant accounting policies or their application. The communication also extends to the effect of significant accounting policies in controversial or emerging areas for which authoritative guidance or consensus is lacking. An example of such an area is revenue recognition.

49 A CPA had previously communicated a significant control deficiency in connection with an audit of prior financial statements of a nonissuer. As of the current audit date, the deficiency has not been corrected. What communication should be made by the CPA? A. The condition should be reported. B. None, because management has been previously put on notice and now has sole responsibility. C. A new communication is required only if it involves an area in which the auditor has not relied on the controls. D. A new communication is required only if the auditor has relied on the controls.

Answer (A) is correct. AU-C 265 requires communication about significant deficiencies and material weaknesses and makes no exception solely for previous reporting of a condition. This can be accomplished by a written communication referring to the previously written communication and the date of that communication.

Which of the following statements is true about the use of the work of an auditor's specialist? A. The auditor should obtain an understanding of the methods and assumptions used by the specialist. B. The auditor is required to perform substantive procedures to verify the specialist's assumptions and findings. C. The specialist need not agree to the auditor's use of the specialist's findings. D. The auditor must keep client information confidential, but the specialist is not obligated to do so.

Answer (A) is correct. AU-C 620, Using the Work of an Auditor's Specialist, states that the auditor should evaluate the adequacy of the work of the auditor's specialist. This process includes (1) obtaining an understanding of any significant assumptions and methods used by the specialist and (2) evaluating the relevance and reasonableness of those assumptions and methods in the circumstances and in relation to the auditor's other findings and conclusions.

In assessing the objectivity of internal auditors, the independent CPA who is auditing the entity's financial statements most likely considers the A. Internal auditing standards developed by The Institute of Internal Auditors. B. Materiality of the accounts recently inspected by the internal auditors. C. Tests of internal control activities that could detect errors and fraud. D. Results of the tests of transactions recently performed by the internal auditors.

Answer (A) is correct. According to AU-C 610, the external auditor should obtain an understanding of the internal audit function (part of the entity's monitoring component) when obtaining the understanding of internal control. The purpose is to identify internal audit activities relevant to a financial statement audit. One inquiry customarily made is about the application of professional standards by the internal auditors. If the external auditor plans to use the work of the internal auditors to obtain evidence or to provide direct assistance, (s)he should assess the competence and objectivity of the internal auditors. Compliance with the internal auditing standards developed by The Institute of Internal Auditors or by the Government Accountability Office is one measure of the competence and objectivity of internal auditors. These standards require internal auditors to be objective in performing their work.

82 Subsequent events that provide evidence of conditions that arose subsequent to the date of the financial statements A. May require disclosure in notes to the financial statements. B. Should not be considered for any purposes. C. Require adjustment of the financial statements. D. Should ordinarily be disclosed in the auditor's report.

Answer (A) is correct. According to U.S. GAAP, subsequent events that provide evidence of conditions arising after the balance sheet date but before the statements are issued or available to be issued are not recognized. However, a nonrecognized subsequent event may be of such a nature that it must be disclosed to keep the statements from being misleading.

Which of the following is not considered an auditor's specialist? A. Internal auditor. B. Actuary. C. Appraiser. D. Tax attorney.

Answer (A) is correct. For the purposes of AU-C 620, an auditor's specialist is an individual or organization possessing expertise in a field other than accounting or auditing. The external auditor should consider the work of internal auditors but should not deem them to be specialists in the sense contemplated by AU-C 620.

Question: 97 On February 25, financial statements were released with an auditor's report expressing an unmodified opinion on the statements for the year ended January 31. On March 2, the CPA learned that on February 11, the entity incurred a material loss on an uncollectible trade receivable as a result of the deteriorating financial condition of the entity's principal customer that led to the customer's bankruptcy. Management then refused to adjust the financial statements for this subsequent event. The CPA determined that the information is reliable and that creditors are currently relying on the financial statements. The CPA's next course of action most likely is to A. Notify management and those charged with governance that the auditor will seek to prevent future reliance on the auditor's report. B. Issue a revised auditor's report and distribute it to each creditor known to be relying on the financial statements. C. Issue revised financial statements and distribute them to each creditor known to be relying on the financial statements. D. Notify the entity's creditors that the financial statements and the related auditor's report should no longer be relied on.

Answer (A) is correct. If management does not take the necessary steps to revise the financial statements and ensure that anyone in receipt of the audited financial statements is informed of the situation, the auditor should notify management and those charged with governance that the auditor will seek to prevent future reliance on the auditor's report. If, despite such notice, management or those charged with governance do not take the necessary steps, the auditor should take appropriate action to prevent reliance on the auditor's report (AU-C 560).

In assessing the competence of an internal auditor, an independent CPA most likely would obtain information about the A. Quality of the internal auditor's documentation. B. Organizational levels to which the internal auditor reports. C. Influence of management on the scope of the internal auditor's duties. D. Organization's commitment to integrity and ethical values.

Answer (A) is correct. In assessing the competence of an internal auditor, the auditor should consider such factors as (1) educational level and professional experience; (2) professional certification and continuing education; (3) audit policies, programs, and procedures; (4) supervision and review of the internal auditor's activities; (5) practices regarding assignments; (6) quality of documentation, reports, and recommendations; and (7) evaluation of the internal auditor's performance.

A CPA has received legal counsel's letter in which no significant disagreements with the client's assessments of contingent liabilities were noted. The resignation of the client's legal counsel shortly after receipt of the letter should alert the auditor that A. Undisclosed unasserted claims may have arisen. B. The auditor must begin a completely new examination of contingent liabilities. C. Legal counsel was unable to form a conclusion with respect to the significance of litigation, claims, and assessments. D. An adverse opinion will be necessary.

Answer (A) is correct. Legal counsel may be required to resign from an engagement (under his or her Code of Professional Responsibility) if the client disregards advice about financial accounting and reporting for litigation, claims, and assessments. Because the response to the letter of inquiry stated that the client's assessment of contingent liabilities was satisfactory, the source of disagreement may be undisclosed, unasserted claims.

71 A CPA had the management of Paper Plate Corp. prepare a letter requesting Paper Plate's external counsel to identify any pending and/or unasserted claims against Paper Plate. The CPA received a letter from the external counsel with the following response: "We are only aware of the following: Paper Plate was named as the defendant in a class action lawsuit for an alleged defective product manufactured 2 years ago. There is a remote possibility that Paper Plate will suffer any damages, because this firm has successfully defended similar cases in the past. However, similar cases that have been brought against competitors were settled between $1.5 and $2 million." Should the CPA accept the letter from the external counsel? A. Yes, even though the CPA did not get a specific amount of loss. B. No, because the CPA allowed Paper Plate to prepare the letter. C. No, because the CPA did not consult a specialist in class action suits. D. Yes, if the CPA discusses the prior lawsuits with the competitors' lawyers.

Answer (A) is correct. No specific amount of loss is required. The external counsel believes the possibility is remote that the company will suffer any damages.

An auditor is most likely to communicate to those charged with governance that A. The auditor encountered significant difficulties during the audit. B. Management agreed with the auditor's assessed risks of material misstatement. C. The turnover in the accounting department was unusually high. D. The auditor discovered subsequent events.

Answer (A) is correct. Significant difficulties encountered during the audit may result in a scope limitation. Accordingly, the auditor communicates such matters as (1) delays in receiving required information from management, (2) an unnecessarily brief time to perform the audit, (3) extensive and unexpected effort to obtain audit evidence, (4) unavailability of expected information, (5) restrictions placed on the auditor by management, and (6) management's unwillingness to provide information about its plans to respond to going concern issues (AU-C 260).

83 Subsequent events are defined as events that occur subsequent to the A. Balance sheet date but prior to the auditor's report date. B. Date of the auditor's report and concern contingencies that are not reflected in the financial statements. C. Date of the auditor's report. D. Release of the financial statements.

Answer (A) is correct. Subsequent events occur between the date of the financial statements and the date of the auditor's report. The auditor should perform procedures to determine whether subsequent events that require adjustment of, or disclosure in, the statements are appropriately reflected in the statements in accordance with the applicable financial reporting framework (AU-C 560).

Question: 87 Which of the following procedures will an auditor most likely perform to obtain evidence about the occurrence of subsequent events? A. Inquiring of the entity's legal counsel concerning litigation, claims, and assessments arising after year end. B. Investigating changes in equity occurring after year end. C. Confirming bank accounts established after year end. D. Recomputing a sample of large-dollar transactions occurring after year end for arithmetic accuracy.

Answer (A) is correct. Subsequent events procedures include (1) reading the latest subsequent interim statements, if any; (2) inquiring of management and those charged with governance about the occurrence of subsequent events and various financial and accounting matters; (3) reading the minutes of meetings of owners, management, and those charged with governance; (4) obtaining a letter of representations from management; (5) inquiring of client's legal counsel; and (6) obtaining an understanding of management's procedures for identifying subsequent events.

Which of the following groups is considered a subgroup ordinarily charged with assisting the board of directors in fulfilling its oversight responsibilities? A. Audit committee. B. Senior management. C. Internal auditors. D. Secured creditors.

Answer (A) is correct. The audit committee is a subgroup of the board of directors that is responsible for the oversight of financial reporting.

When auditing related party transactions, an auditor places primary emphasis on A. Assessing the risks of material misstatement of related party transactions. B. Verifying the valuation of the related party transactions. C. Confirming the existence of the related parties. D. Ascertaining the rights and obligations of the related parties.

Answer (A) is correct. The auditor has a responsibility to perform audit procedures to identify, assess, and respond to the risks of material misstatement arising from the entity's failure to appropriately account for or disclose related party relationships, transactions, or balances.

The auditor is required to communicate each of the following items to those charged with governance except A. All control deficiencies detected during the course of the audit. B. The auditor's responsibilities to complete the audit in accordance with generally accepted auditing standards. C. An overview of the planned scope and timing of the audit. D. Any significant findings from the audit.

Answer (A) is correct. The auditor should communicate in writing significant deficiencies and material weaknesses, not all control deficiencies, to management and those charged with governance.

Which of the following matters in a financial statement audit is most appropriate to communicate with those charged with governance? A. An overview of the planned scope and timing of the audit. B. Clearance explanations of workpaper review notes. C. The nature and timing of detailed audit procedures. D. Major variances in budgeted versus actual audit hours.

Answer (A) is correct. The auditor should communicate with those charged with governance (1) the auditor's responsibilities under generally accepted auditing standards, (2) an overview of the planned scope and timing of the audit, and (3) significant findings from the audit.

Legal counsel's response to an auditor's inquiry about litigation, claims, and assessments may be limited to matters that are considered individually or collectively material to the client's financial statements. Which parties may reach an understanding on the limits of materiality for this purpose that are stated in the letter of inquiry? A. The auditor and the client's management. B. The client's management and legal counsel. C. Legal counsel and the auditor. D. The client's audit committee and legal counsel.

Answer (A) is correct. The letter of inquiry is prepared by management and sent by the auditor to the entity's legal counsel. Among other things, the letter requests a statement about the nature of, and reasons for, any limitation on legal counsel's response. Legal counsel may limit the response to matters to which (s)he has given substantive attention in the form of legal consultation or representation. Furthermore, legal counsel's response may be limited to those matters that are considered individually or collectively material to the financial statements, such as when the entity and the auditor have agreed on materiality limits, and management has stated the limits in the letter of inquiry (AU-C 501). NOTE: According to the American Bar Association's statement of policy, the lawyer may wish to reach an understanding with the auditor about the test of materiality. However, the lawyer need not do so if (s)he assumes responsibility for the criteria.

Which of the following statements about litigation, claims, and assessments extracted from a letter from a client's legal counsel is most likely to cause the auditor to request clarification? A. "I believe that the action can be settled for less than the damages claimed." B. "I believe that the plaintiff's case against the company is without merit." C. "I believe that the possible liability to the company is nominal in amount." D. "I believe that the company will be able to defend this action successfully."

Answer (A) is correct. The letter of inquiry requests, among other things, that legal counsel evaluate the likelihood of pending or threatened litigation, claims, and assessments. It also requests that legal counsel estimate, if possible, the amount or range of potential loss. Thus, the auditor is concerned about the amount of the expected settlement as well as the likelihood of the outcome. The statement that the action can be settled for less than the damages claimed is an example given in AU-C 501 of an evaluation that is unclear about the likelihood of an unfavorable outcome.

73 If a nonissuer refuses to give permission to the auditor to communicate with its external legal counsel, then the auditor should modify which of the following? A. The opinion in the auditor's report. B. The audit plan. C. The attorney's letter of inquiry. D. The management representation letter.

Answer (A) is correct. The opinion in the auditor's report is modified if legal counsel refuses to respond appropriately to the audit letter of inquiry and the auditor cannot obtain sufficient appropriate evidence by performing alternative procedures. Modification also is required if management refuses permission for the auditor to communicate or meet with external legal counsel. Moreover, external legal counsel's refusal to provide (orally or in writing) information requested in a letter of inquiry may be a scope limitation sufficient to preclude an unmodified opinion. However, the need for confidentiality of client communications with legal counsel protects some matters from disclosure even to the auditor.

Which of the following procedures will most likely assist an auditor in determining whether management has identified all accounting estimates that could be material to the financial statements? A. Review the lawyer's letter for information about litigation. B. Inquire about the existence of related party transactions. C. Confirm inventories at locations outside the entity. D. Determine whether the outcomes of accounting estimates differ from the amounts originally recognized.

Answer (A) is correct. The response to the letter of audit inquiry sent to the client's lawyer may help the auditor to determine whether material estimates have been identified concerning litigation, claims, and assessments.

Question: 101 The U.S. Tax Court ruled in favor of Defendant Co. after year end but before completion of the audit. Litigation involved deductions claimed on prior years' tax returns. The company had credited accrued taxes payable at year end for the full amount sought by the IRS. The IRS will not appeal the ruling. What is the effect of this event on the year-end statements? A. Adjustment of the financial statements. B. Disclosure by means of supplemental, pro forma financial data. C. Disclosure in a note to the financial statements. D. No financial statement revision.

Answer (A) is correct. The ruling of the Tax Court provides additional evidence about conditions that existed at the date of the financial statements and affects the estimates used in their preparation. Consequently, the settlement in the subsequent events period for an amount different from that recorded requires the client to adjust the statements.

47 Under the AICPA's auditing standards, which of the following statements about an auditor's communication of significant control deficiencies is true? A. A significant control deficiency previously communicated during the prior year's audit that remains uncorrected causes a scope limitation. B. An auditor's report on significant control deficiencies should include a restriction on the use of the report. C. An auditor should communicate significant control deficiencies after tests of controls, but before commencing substantive tests. D. An auditor should perform tests of controls on significant control deficiencies before communicating them to the client.

Answer (B) is correct. A communication of significant control deficiencies should (1) state that the purpose of the audit was to report on the financial statements, not to provide assurance on internal control; (2) give the definition of significant control deficiencies and material weaknesses; and (3) state that the report is intended solely for the information and use of those charged with governance, management, and others within the organization (or specified regulatory agency) and is not intended to be, and should not be, used by anyone other than the specified parties.

The letter of audit inquiry addressed to the client's external legal counsel will not ordinarily be A. Used to corroborate the information originally obtained from management concerning litigation, claims, and assessments. B. Limited to references concerning only pending or threatened litigation in connection with which the legal counsel has been engaged. C. Needed during the audit of clients whose securities are not registered with the SEC. D. Sent to legal counsel who was engaged by the audit client during the year and soon thereafter resigned the engagement.

Answer (B) is correct. A letter of audit inquiry to a client's external legal counsel includes, but is not limited to, management-prepared lists of unasserted claims and assessments as well as pending or threatened litigation, claims, and assessments in connection with which legal counsel has been engaged. Legal counsel is expected to respond appropriately (within the limits of materiality) if (s)he has given substantive attention to any of these matters on behalf of the entity in the form of legal consultation or representation.

Which of the following would not necessarily be a related party transaction? A. Loan from the corporation to a major shareholder. B. A sale to another corporation with a similar name. C. A purchase from another corporation that is controlled by the corporation's chief shareholder. D. Sale of land to the corporation by the spouse of a director.

Answer (B) is correct. A related party is a party defined as such in the applicable financial reporting framework. For example, U.S. GAAP define related parties to include (1) affiliates; (2) equity-method investees or investees that would be equity-method investees if the fair value option had not been elected; (3) employee trusts; (4) management, principal owners, and their immediate families; (5) other parties with which the entity may deal if one party controls or can be significantly influenced by the other to the extent that a party may be prevented from pursuing its separate interests; and (6) other parties that can significantly influence the transacting parties to the extent that a party may be prevented from pursuing its separate interests. A corporation that merely has a similar name is not necessarily related.

Question: 100 After an audit report containing an unmodified opinion on a nonissuer's financial statements was dated and the financial statements issued, the client decided to sell the shares of a subsidiary that accounts for 30% of its revenue and 25% of its net income. The auditor should A. Notify the entity that the auditor's report may no longer be associated with the financial statements. B. Take no action because the auditor has no obligation to make any further inquiries. C. Describe the effects of this subsequently discovered information in a communication with persons known to be relying on the financial statements. D. Determine whether the information is reliable and, if determined to be reliable, request that revised financial statements be issued.

Answer (B) is correct. AU-C 560 states, "The auditor is not required to perform any audit procedures regarding the financial statements after the date of the auditor's report."

45 When communicating significant deficiencies in internal control noted in a financial statement audit of a nonissuer, the communication should indicate that A. Fraud or errors may occur and not be detected because of the inherent limitations of internal control. B. The purpose of the audit was to report on the financial statements, not to provide assurance on internal control. C. The deficiencies noted were not detected within a timely period by employees in the normal course of performing their assigned functions. D. The expression of an unmodified opinion on the financial statements may be dependent on corrective follow-up action.

Answer (B) is correct. According to an illustrative written communication in AU-C 265, the auditors state, "we considered the Company's internal control over financial reporting (internal control) as a basis for designing audit procedures that are appropriate in the circumstances for the purpose of expressing our opinion on the financial statements, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control. Accordingly, we do not express an opinion on the effectiveness of the Company's internal control."

Under which of the following circumstances would an auditor be considered to be using the work of a specialist? A. The auditor makes inquiries of the client's lawyer regarding pending litigation. B. The auditor engages a lawyer to interpret the provisions of a complex contract. C. A tax expert employed by the auditor's CPA firm reviews the client's tax accruals. D. The client engages an outside computer service organization to prepare its payroll.

Answer (B) is correct. An auditor's specialist is an individual or organization possessing expertise in a field other than accounting or auditing. The work in that field is used to assist the auditor in obtaining sufficient appropriate audit evidence.

In assessing the competence and objectivity of an entity's internal auditor, an independent auditor would least likely consider information obtained from A. Previous experience with the internal auditor. B. The results of analytical procedures. C. External quality reviews of the internal auditor's activities. D. Discussions with management personnel.

Answer (B) is correct. Analytical procedures are evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data, using models that range from simple to complex. They are substantive procedures used by the auditor to gather evidence about the fairness of the financial statements.

U.S. GAAP ordinarily require material related party transactions to be A. Separately disclosed and accounted for differently from transactions between unrelated parties. B. Separately disclosed but not accounted for differently from transactions between unrelated parties. C. Accounted for on the same basis as transactions between unrelated parties and not separately disclosed. D. Accounted for differently from transactions between unrelated parties but not separately disclosed.

Answer (B) is correct. Certain accounting pronouncements prescribe accounting treatment when related parties are involved. However, U.S. GAAP ordinarily do not require transactions with related parties to be accounted for on a basis different from what would be appropriate if the parties were not related.

76 Which of the following statements best expresses the auditor's responsibility with respect to events occurring after the balance-sheet date? A. The auditor's responsibility is to determine that transactions recorded on or before the balance-sheet date actually occurred. B. The auditor is responsible for identifying subsequent events affecting the financial statements. C. The auditor has no responsibility for events occurring in the subsequent period unless these events affect transactions recorded on or before the balance-sheet date. D. The auditor is fully responsible for subsequent events and should extend all detailed procedures through the last day of field work.

Answer (B) is correct. Events that have a material effect on the financial statements sometimes occur subsequent to the balance-sheet date but prior to the auditor's report date and, therefore, require adjustment of, or disclosure in, the statements. Certain specific procedures, such as the determination that proper cutoffs have been made and the examination of data to aid in evaluating assets and liabilities as of the balance-sheet date, are normally applied in this period. Other phases of the audit, however, will have been substantially completed by year end. The auditor is responsible for obtaining sufficient appropriate evidence about subsequent events that require adjustment of, or disclosure in, the statements. This responsibility extends to determining whether subsequent events are appropriately reflected in those statements.

Which of the following statements is correct regarding an independent auditor's reliance on a client's internal audit staff? A. An internal auditor should provide direct assistance to the independent auditor during preparation of audit workpapers. B. An independent auditor should assess the organizational status of the director of internal audit. C. An independent auditor should use internal audit workpapers when available. D. An independent auditor should not reduce the amount of audit testing based on the work of internal auditors.

Answer (B) is correct. Given an expectation of using the work of the internal auditors, the external auditor's objectives include determining (1) whether to use their work and in what ways and (2), if using their work, whether it is adequate for audit purposes. To determine whether internal audit work can be used to obtain audit evidence, the external auditor should evaluate (1) the competence of the internal audit function, (2) the extent to which its organizational status and policies and procedures support its objectivity, and (3) its application of a systematic and disciplined approach (including quality control). Factors affecting objectivity include whether the internal audit function's organizational status supports its ability to be free from bias, conflict of interest, or undue influence. For example, the external auditor should determine whether the internal audit function reports to (1) those charged with governance, (2) an officer with appropriate authority, or (3) management but with direct access to those charged with governance.

If the auditors plan to use the work of the internal auditors to obtain audit evidence or to provide direct assistance, they should assess the internal auditors' A. Efficiency and experience. B. Competence and objectivity. C. Independence and review skills. D. Training and supervisory skills.

Answer (B) is correct. If the external auditor decides to use the work of the internal auditors, the competence and objectivity of the internal auditors should be assessed. Assessing competence involves obtaining information about (1) education and experience; (2) professional certification and CPE; (3) audit policies, programs, and procedures; (4) practices regarding assignment of internal auditors; (5) supervision and review of their activities; (6) quality of audit documentation, reports, and recommendations; and (7) evaluation of internal auditors' performance. Assessing objectivity includes obtaining information about (1) organizational status (the level to which the internal auditors report, access to those charged with governance, and whether these individuals oversee employment decisions related to the internal auditors) and (2) policies to maintain internal auditors' objectivity concerning the areas audited (AU-C 610).

Disclosure in financial statements of a reporting entity that has participated in related party transactions that are material, individually or in the aggregate, should include all of the following except A. The dollar amounts of the transactions, amounts due from or to related parties, and, if not otherwise apparent, the terms and manner of settlement. B. A statement that the transactions would have occurred regardless of whether the parties were related. C. The nature of the relationship. D. A description of the transactions for the period reported upon including amounts, if any, and such other information necessary to an understanding of the effects on the financial statements.

Answer (B) is correct. It is ordinarily not possible to determine whether a particular transaction would have occurred or what the terms would have been if the parties had not been related.

48 Which of the following representations should not be included in a written report on internal control related matters identified in an audit under the AICPA's auditing standards? A. Corrective action is recommended due to the relative significance of material weaknesses discovered during the audit. B. There are no significant deficiencies or material weaknesses in the design or operation of internal control. C. Significant deficiencies related to the design of internal control exist, but none are deemed to be material weaknesses. D. The auditor's consideration of internal control would not necessarily disclose all significant deficiencies or material weaknesses that exist.

Answer (B) is correct. No report should be issued indicating that no significant deficiencies were noted. The potential for misinterpretation would exist if the auditor issued such a report (AU-C 265).

In the absence of evidence to the contrary, transactions with related parties should not be assumed to be outside the normal course of business. The auditor should, however, be aware of the possibility that transactions with related parties may have been motivated solely or in large part by extraordinary conditions. Which of the following is not normally a condition motivating a transaction outside the normal course of business? A. Dependence on a single or relatively few product(s), customer(s), or transaction(s) for the ongoing success of the venture. B. Mutual benefit to both parties. C. Lack of sufficient working capital or credit to continue business. D. An overly optimistic earnings forecast.

Answer (B) is correct. Parties customarily execute transactions that are mutually beneficial. These are considered within the normal course of business. The absence of mutual benefit is an indication that the transaction is not at arm's-length and that special disclosure is required to prevent the statements from being misleading. Thus, related party transactions may indicate an increased risk of material misstatement of the statements.

75 Which of the following procedures will an auditor most likely perform to obtain evidence about the occurrence of subsequent events? A. Investigating personnel changes in the accounting department occurring after year end. B. Inquiring as to whether any unusual adjustments were made after year end. C. Comparing the financial statements being reported on with those of the prior period. D. Confirming a sample of material accounts receivable established after year end.

Answer (B) is correct. Subsequent events procedures include inquiring of management as to whether (1) subsequent events occurred that might affect the statements; (2) new commitments, borrowings, or guarantees were made; (3) sales or acquisitions of assets occurred or were planned; (4) capital increased or debt was issued; (5) developments regarding contingencies occurred; (6) any events occurred (a) casting doubt on the appropriateness of accounting policies or (b) that are relevant to the measurement of estimates or the recovery of assets; (7) any unusual accounting adjustments were made or considered; and (8) changes occurred in the current status of items that were accounted for on the basis of preliminary or inconclusive data.

81 On January 15, Year 2, before the Mapleview Co. released its financial statements for the year ended December 31, Year 1, it settled a long-standing lawsuit. A material loss resulted and no prior liability had been recorded. How should this loss be disclosed or recognized? A. The loss should be disclosed in an explanatory paragraph in the auditor's report. B. The financial statements should be adjusted to recognize the loss. C. The loss should be disclosed in notes to the financial statements, but the financial statements themselves need not be adjusted. D. No disclosure or recognition is required.

Answer (B) is correct. Subsequent events that provide evidence of conditions that existed at the balance sheet date and that require adjustment of the financial statements should be reflected in those statements in accordance with the applicable financial reporting framework. For example, U.S. GAAP require recognition in the statements of the effects of a subsequent event providing additional evidence about conditions at the balance sheet date, including accounting estimates. Settlement of a lawsuit is indicative of conditions existing at year end and calls for adjustment of the statements.

In using the work of an auditor's external specialist, an agreement should exist between the auditor and the specialist as to the nature of the specialist's work. This agreement most likely should include A. A statement that the specialist assumes no responsibility to update the specialist's report for future events or circumstances. B. The applicability of the same confidentiality requirements to the auditor and the specialist. C. The auditor's disclaimer as to whether the specialist's findings corroborate the representations in the financial statements. D. The conditions under which a division of responsibility may be necessary.

Answer (B) is correct. The agreement should be documented and should cover (1) the nature, objectives, and scope of the work; (2) the roles of the auditor and specialist; (3) the nature, timing, and extent of communications between the auditor and specialist; and (4) the need for the specialist to observe confidentiality requirements. The agreement between the auditor and the auditor's external specialist generally is documented in an engagement letter. A matter that should be included is the need for the confidentiality provisions of the relevant ethical requirements that apply to the auditor also to apply to the specialist. For example, a member of the AICPA may use a third-party service provider to render professional services to clients. The member should have a contract with the third-party service provider to maintain the confidentiality of the information (Ethics Ruling). Other requirements may be imposed by law or regulation.

56 An auditor should communicate misstatements to those charged with governance A. Even if they are clearly trivial. B. If they are uncorrected. C. If they were not recorded before the end of the auditor's field work. D. If they are immaterial and corrected but frequently recurring.

Answer (B) is correct. The auditor communicates uncorrected misstatements and the effect they may have, individually or aggregated, on the opinion. Furthermore, material uncorrected misstatements should be identified individually. Also, the auditor should communicate to those charged with governance the effect of uncorrected misstatements related to prior periods (AU-C 260).

Which of the following statements is true about related party transactions? A. In the absence of evidence to the contrary, related party transactions should be assumed to be outside the ordinary course of business. B. The auditor should consider whether an identified related party transaction outside the normal course of business is appropriately accounted for and disclosed. C. An auditor should determine whether a particular transaction would have occurred if the parties had not been related. D. An auditor should substantiate that related party transactions were consummated on terms equivalent to those that prevail in arm's-length transactions.

Answer (B) is correct. The auditor should inspect any contracts or agreements to evaluate whether (1) the business purpose (or lack of a business purpose) implies that the transaction's intent was fraudulent, (2) the terms are consistent with management's explanations, and (3) the accounting and disclosure are appropriate. The auditor also should obtain evidence of appropriate authorization and approval.

The client has equity securities classified as available for sale. The auditor is most concerned about controls related to A. Why specific securities were purchased. B. The determination of the fair value measurements of the securities. C. When the securities will be sold. D. The accrued interest receivable for the securities.

Answer (B) is correct. The auditor should obtain an understanding of (1) the client's process for the determination of fair value measurements and disclosures and (2) the relevant controls. Available-for-sale and trading securities are required to be reported at fair value by U.S. GAAP.

69 The appropriate date for the client to specify as the effective date in the audit inquiry to legal counsel is A. The date of the audit inquiry itself. B. As close to the date of the auditor's report as possible. C. Seven working days after the request is received by legal counsel. D. The balance-sheet date.

Answer (B) is correct. The date of legal counsel's response should be as close to the date of the auditor's report as practicable. The auditor is concerned with events occurring through the date of the report that may require adjustment to, or disclosure in, the financial statements. The date of the report is the date on which the auditor obtained sufficient appropriate audit evidence on which to base the opinion. Moreover, the auditor should specify the earliest acceptable effective date of the response and the latest date by which it is to be sent to the auditor. A 2-week period between these dates generally suffices.

An auditor concludes that the omission of a substantive procedure considered necessary at the time of the audit may impair the auditor's current ability to support the previously expressed opinion. The auditor need not apply the omitted procedure if A. The auditor's opinion was qualified because of a material misstatement. B. The results of other procedures that were applied tend to compensate for the procedure omitted. C. The risk of adverse publicity or litigation is low. D. The results of the subsequent period's tests of controls make the omitted procedure less important

Answer (B) is correct. The results of other procedures applied or audit evidence obtained in a later audit (possibly at an interim date) may compensate for an omitted procedure. Furthermore, the auditor should assess the importance of the omitted procedure to his or her current ability to support the previously expressed audit opinion.

During the audit of fair value estimates and disclosures, the auditor most likely should A. Understand the components of internal control but need not specifically obtain an understanding of the entity's process for determining fair value estimates. B. Use the understanding of the audited entity's process for determining fair value estimates to assess the risks of material misstatement. C. Determine that the entity has measured fair value estimates using discounted cash flows whenever feasible. D. Focus primarily on the initial recording of transactions.

Answer (B) is correct. To meet its responsibility to make the fair value estimates included in the financial statements, management must adopt financial reporting processes that include (1) adequate internal control, (2) selecting appropriate accounting policies, (3) prescribing estimation processes (e.g., valuation methods, including models), (4) determining data and assumptions, (5) reviewing the circumstances requiring estimation, and (6) making necessary reestimates. The auditor should obtain an understanding of these processes and the relevant controls. It should be sufficient for an effective audit of fair value estimates. The understanding is used to assess the risks of material misstatement. Assessing these risks includes evaluating (1) estimation uncertainty (inherent lack of measurement precision) and (2) determining whether the risks are significant.

Which of the following is an unusual procedure that may be deemed necessary to discover the effect of a related party transaction? A. Determine whether the transaction has been approved by management, those charged with governance, or shareholders. B. Confirm significant information with third parties other than banks or attorneys. C. Examine invoices and other pertinent documents such as receiving or shipping reports. D. Inspect or confirm the transferability and value of collateral.

Answer (B) is correct. To understand fully a related party transaction, certain procedures not otherwise required to comply with auditing standards should be considered. Third-party confirmations (other than bank and legal confirmations) are unusual procedures that might be applied when necessary to understand a related party transaction.

Some subsequent events provide evidence of conditions not in existence at the balance sheet date. Under U.S. GAAP, some of these events are of such a nature that disclosure is required to keep the financial statements from being misleading. Adequate disclosure of these events may include A. Notes to the auditor's report. B. Pro forma financial statement presentation. C. Restatement of prior-period financial statements. D. Adjustment of the financial statements.

Answer (B) is correct. Under U.S. GAAP, subsequent events related to conditions that did not exist at the date of the balance sheet should not result in adjustments of (recognition in) the financial statements. These events are disclosed, if necessary, to keep the financial statements from being misleading. Occasionally, such an event may be so significant that disclosure can best be made by means of pro forma financial data. Such data make the event seem as if it had occurred on the date of the balance sheet. In some cases, U.S. GAAP suggest presentation of pro forma statements, usually a balance sheet only, in columnar form on the face of the historical statements. But firms usually incorporate the pro forma balance sheets in notes.

50 To what degree, if at all, is a significant deficiency related to a material weakness? A. It is unrelated to a material weakness. B. It is equivalent to a material weakness. C. It is less severe than a material weakness. D. It is more severe than a material weakness.

Answer (C) is correct. A significant deficiency is a deficiency, or combination of deficiencies, in internal control that is less severe than a material weakness but that merits attention by those charged with governance.

Question: 89 Wilson, CPA, obtained sufficient appropriate audit evidence on which to base the opinion on Abco's December 31, Year 1, financial statements on March 6, Year 2, the date of the auditor's report. A subsequently discovered fact requiring revision of the Year 1 financial statements occurred on April 10, Year 2, and came to Wilson's attention on April 24, Year 2. If the fact became known prior to the report release date, and the revision is made, Wilson's report ordinarily should be dated A. March 6, Year 2. B. April 24, Year 2. C. Using dual dating. D. April 10, Year 2.

Answer (C) is correct. A subsequently discovered fact (1) becomes known to the auditor after the report date and (2) may cause the auditor to revise the report. The report date is no earlier than the date when sufficient appropriate evidence is obtained. If such a fact becomes known to the auditor before the report release date, the auditor should (1) discuss the matter with management and (2) determine whether the statements need revision (adjustment or disclosure). If management revises the statements, the auditor should perform the necessary procedures on the revision. The auditor also (1) dates the report as of a later date or (2) dual-dates the report. Dual-dating indicates that the procedures performed subsequent to the original date are limited to the revision. Unless the auditor extends subsequent events procedures to a new date (one presumably later than April 24, Year 2, the date when the subsequently discovered fact became known), the auditor should dual-date the report.

When one party can significantly influence the management or operating policies of the other to the extent that one of the transacting parties might be prevented from fully pursuing its separate interests, the parties are related for purposes of AU-C 550. Which of the following is not usually regarded as a party related to an entity? A. Third parties that can significantly influence the operating policies of the transacting parties. B. Affiliates, principal owners, and entities for which investments are accounted for by the equity method. C. The U.S. government. D. Management and members of their immediate families.

Answer (C) is correct. Although the U.S. government regulates many aspects of business activity, it is not considered a related party when dealing with an entity.

Question: 94 After issuing an auditor's report, an auditor has no obligation to make continuing inquiries about audited financial statements unless A. Information about a material transaction that occurred just after the auditor's report was issued is deemed to be reliable. B. A final resolution is made of a contingent liability that had been disclosed in the financial statements. C. Information that existed at the report date and may affect the report comes to the auditor's attention. D. An event occurs just after the auditor's report was issued that affects the entity's ability to continue as a going concern.

Answer (C) is correct. Although the auditor may need to extend subsequent events procedures when issuers make filings under the Securities Act of 1933 (AU-C 925, Filings with the U.S. Securities and Exchange Commission Under the Securities Act of 1933), (s)he ordinarily need not apply any procedures after the date of the report. However, facts may be discovered by the auditor after the report release date that, if known at that date, might have caused the auditor to revise the report. In this case, the auditor should (1) discuss the matter with management and (2) determine whether the statements should be revised and, if so, how management intends to address the matter in the statements (AU-C 560).

54 Which of the following matters should an auditor communicate to those charged with governance? A. The justification for performing substantive procedures at interim dates. B. The basis for assessing the risks of material misstatement when the auditor intends to rely on controls. C. The process used by management in formulating sensitive accounting estimates. D. The auditor's preliminary judgments about materiality levels.

Answer (C) is correct. Certain accounting estimates are particularly sensitive because they are significant to the financial statements, and future events affecting them may differ from current judgments. Those charged with governance should be informed about the process used in formulating sensitive estimates, including fair value estimates, and the basis for the auditor's conclusions about their reasonableness (AU-C 260).

52 During planning, an auditor of a nonissuer should communicate which of the following to those charged with governance at an entity? A. The auditor is responsible for preparing financial statements in conformity with the applicable financial reporting framework. B. All audit findings will be communicated in writing to those charged with governance. C. The audit does not relieve management of its responsibilities for the financial statements. D. The auditor will express an opinion on the effectiveness of internal controls over compliance with laws and regulations.

Answer (C) is correct. Effective two-way communication, among other things, assists those charged with governance to fulfill their responsibility to oversee the financial reporting process. The result should be reduced risk of material misstatement. Communications with management should address its responsibility for the preparation and fair presentation of the financial statements.

Question: 96 Which of the following events occurring after the date of the report most likely will cause the auditor to make further inquiries about the previously issued financial statements? A. The final resolution of a lawsuit explained in a separate paragraph of the auditor's report. B. A technological development that could affect the entity's future ability to continue as a going concern. C. The discovery of information regarding a contingency that existed before the financial statements were issued. D. The entity's sale of a subsidiary that accounts for 30% of the entity's consolidated sales.

Answer (C) is correct. Facts may be discovered by the auditor after the date of the report that, if known at that date, might have caused the auditor to revise the report. In this case, the auditor should (1) discuss the matter with management and (2) determine whether the statements should be revised and, if so, how management intends to address the matter in the statements (AU-C 560).

Which of the following is not an audit procedure that the auditor performs with respect to litigation, claims, and assessments? A. Obtain assurance from management that it has disclosed all unasserted claims that legal counsel has advised are probable of assertion and must be disclosed. B. Inquire of and discuss with management the policies and procedures adopted for litigation, claims, and assessments. C. Confirm directly with the client's legal counsel that all claims have been recorded in the financial statements. D. Obtain from management a description and evaluation of litigation, claims, and assessments that existed at the balance sheet date.

Answer (C) is correct. Legal counsel's expertise does not extend to accounting matters. Legal counsel evaluates whether claims may be asserted and the likelihood and magnitude of the outcomes. These evaluations bear upon accounting and reporting decisions, for example, whether disclosure only or recognition of a contingent liability is required. But all claims do not necessarily require recognition, and legal counsel does not have information about the content of financial statements that have not been issued.

70 The refusal of a client's legal counsel to provide a representation on the legality of a particular act committed by the client is ordinarily A. Insufficient reason to modify the auditor's report because of the legal counsel's obligation of confidentiality. B. Proper grounds to withdraw from the engagement. C. A scope limitation. D. Sufficient reason to express a "subject to" opinion.

Answer (C) is correct. Legal counsel's refusal either orally or in writing to provide the requested information may be a scope limitation sufficient to preclude an unmodified opinion. The reason is that the letter of inquiry to the client's legal counsel is the primary means of corroborating management's representations about litigation, claims, and assessments. However, a statement in the letter such as, "It would be inappropriate for this firm to respond to a general inquiry relating to the existence of unasserted possible claims and assessments," is not considered a scope limitation. The quoted language is based on the preamble of the American Bar Association's statement of policy regarding lawyers' responses to auditors' requests for information.

41 Which of the following factors would the independent auditor most likely consider in assessing the objectivity of an internal auditor? A. The internal auditor attends a number of comprehensive continuing professional education courses each year. B. The internal auditor was previously an employee of the auditor's public accounting firm. C. The audit committee reviews employment decisions related to the director of internal auditing. D. The internal auditor has obtained the Certified Internal Auditor designation.

Answer (C) is correct. Objectivity is impartiality, intellectual honesty, and freedom from conflicts of interest. Factors that the independent auditor most likely considers in assessing the objectivity of an internal auditor include whether those charged with governance (e.g., the audit committee) oversee employment decisions related to internal auditing. Examples are hiring and compensation of the director of the internal audit function.

As part of the audit of fair value estimates and disclosures, an auditor may need to test the entity's significant assumptions. In these circumstances, the auditor should A. Verify that the entity has used its own assumptions, not those of marketplace participants. B. Obtain sufficient evidence to express an opinion on the assumptions. C. Evaluate whether the assumptions individually and as a whole form a reasonable basis for the fair value estimates. D. Apply audit effort equally to all assumptions.

Answer (C) is correct. Observable market prices are not always available for fair value estimates. In this case, the entity uses valuation methods based on the assumptions that the market would employ to estimate fair values, if obtainable without excessive cost. Accordingly, GAAS require the auditor to evaluate whether the significant assumptions form a reasonable basis for the estimates. Because assumptions often are interdependent and must be consistent with each other, the auditor should evaluate them independently and as a whole.

80 Which of the following procedures should an auditor ordinarily perform regarding subsequent events? A. Review the cutoff bank statements for several months after the year end. B. Communicate material weaknesses in internal control to the client's audit committee. C. Read the latest subsequent interim financial statements. D. Send second requests to the client's customers who failed to respond to initial accounts receivable confirmation requests.

Answer (C) is correct. Subsequent events procedures include (1) reading the latest subsequent interim statements, if any; (2) inquiring of management and those charged with governance about the occurrence of subsequent events and various financial and accounting matters; (3) reading the minutes of meetings of owners, management, and those charged with governance; (4) obtaining a letter of representations from management; (5) inquiring of client's legal counsel; and (6) obtaining an understanding of management's procedures for identifying subsequent events.

Question: 88 Subsequent events affecting the realization of assets ordinarily will require adjustment of the financial statements under audit because such events typically represent the A. Preliminary estimate of losses relating to new events that occurred subsequent to the balance sheet date. B. Final estimates of losses relating to casualties occurring in the subsequent events period. C. Culmination of conditions that existed at the balance sheet date. D. Discovery of new conditions occurring in the subsequent events period.

Answer (C) is correct. Subsequent events that provide evidence of conditions that existed at the balance sheet date and that require adjustment of the financial statements should be reflected in those statements in accordance with the applicable financial reporting framework. For example, U.S. GAAP require recognition in the statements of the effects of a subsequent event providing additional evidence about conditions at the balance sheet date, including accounting estimates. Subsequent events affecting the realization of assets typically represent the culmination of conditions that existed at year end.

79 A major customer of an audit client suffers a fire just prior to completion of year-end field work. The audit client believes that this event could have a significant direct effect on the financial statements. The auditor should A. Advise management to adjust the financial statements. B. Withhold submission of the auditor's report until the extent of the direct effect on the financial statements is known. C. Advise management to disclose the event in notes to the financial statements. D. Disclose the event in the auditor's report.

Answer (C) is correct. Subsequent events, such as a fire or other casualty, that provide evidence of conditions that did not exist at the balance sheet date should not result in adjustment of the financial statements. But some of these subsequent events should be disclosed if required by the applicable financial reporting framework. For example, U.S. GAAP require disclosure to keep the statements from being misleading.

An auditor is assessing the appropriateness of management's rationale for selecting a model to measure the fair value of debt securities. If, during the current year, an active trading market for the debt security was introduced, the auditor should validate each of the following criteria, except whether the valuation model is A. Evaluated and appropriately applied based on generally accepted accounting principles. B. Appropriate for the debt security being valued. C. Consistently applied from prior periods. D. Appropriate for the environment in which the entity operates.

Answer (C) is correct. The active trading market for the debt security was introduced in the current year. Therefore, a prior period cannot be used to validate the valuation model.

42 A secondary result of the auditor's understanding of internal control for a nonissuer is that the understanding may A. Develop evidence to support the assessed risks of material misstatement. B. Assure that management's procedures to detect fraud are properly functioning. C. Bring to the auditor's attention possible control conditions required to be communicated to the client. D. Provide a basis for determining the nature, timing, and extent of audit tests.

Answer (C) is correct. The auditor is not required to search for significant deficiencies or material weaknesses in internal control. However, the auditor may identify these conditions during the audit. Significant deficiencies and material weaknesses should be communicated in writing to management and to those charged with governance (AU-C 265).

When a management's specialist has assumed full responsibility for taking the client's physical inventory, reliance on the specialist's work is acceptable if A. The auditor is satisfied with the competence of the specialist. B. Circumstances made it impracticable or impossible for the auditor to test the work done by the specialist. C. The auditor conducted the same audit tests and procedures as would have been applicable if the client employees took the physical inventory. D. The auditor's report contains a reference to the assumption of full responsibility by the specialist.

Answer (C) is correct. The auditor is responsible for the observation of inventories. The auditor performs this procedure whether the client or an external specialist takes the physical inventory. The auditor should (1) examine the specialist's program, (2) observe its procedures and controls, (3) make or observe some physical counts, (4) recompute calculations, and (5) test intervening transactions.

When performing procedures to identify and assess the risks of material misstatement for accounting estimates, the auditor should A. Analyze historical data used in developing assumptions to determine whether the process is consistent. B. Review transactions occurring prior to the date of the auditor's report that indicate variations from expectations. C. Obtain an understanding of how management developed its estimates. D. Compare independent expectations with recorded estimates to assess management's process.

Answer (C) is correct. The auditor performs risk assessment procedures to provide a basis for identifying and assessing the RMMs for accounting estimates. Thus, the auditor obtains an understanding of the following: (1) the relevant requirements of the applicable financial reporting framework, (2) how management identifies factors that create a need for estimates, and (3) how management makes estimates and the data on which they are based (e.g., methods, models, controls, use of specialists, underlying assumptions, and whether and how the effects of estimation uncertainty are assessed).

After identifying a significant related party transaction outside the entity's normal course of business, an auditor should A. Add an emphasis-of-matter paragraph to the auditor's report to explain the transaction. B. Perform analytical procedures to identify similar transactions that were not recorded. C. Evaluate the business purpose of the transaction. D. Substantiate that the transaction was consummated on terms equivalent to those of an arm's-length transaction.

Answer (C) is correct. The auditor should inspect any contracts or agreements to evaluate whether (1) the business purpose (or lack of a business purpose) implies that the transaction's intent was fraudulent, (2) the terms are consistent with management's explanations, and (3) the accounting and disclosure are appropriate. The auditor also should obtain evidence of appropriate authorization and approval.

The independent auditor should understand the internal audit function as it relates to internal control because A. The procedures performed by the internal audit staff may eliminate the independent auditor's need for considering internal control. B. The understanding of the internal audit function is an important substantive test to be performed by the independent auditor. C. The work performed by internal auditors may be a factor in determining the nature, timing, and extent of the independent auditor's procedures. D. The audit programs, audit documentation, and reports of internal auditors may often be used as a substitute for the work of the independent auditor's staff.

Answer (C) is correct. The auditor should obtain an understanding of the internal audit function when obtaining an understanding of the client's internal control. The understanding should be sufficient to identify internal audit activities relevant to audit planning. Thus, an internal audit function is one of many factors to be considered in determining the nature, timing, and extent of audit procedures.

Ajax, Inc., is an affiliate of the audit client and is audited by another firm of auditors. Which of the following is most likely to be used by the auditor of the client to obtain assurance that all guarantees of the affiliate's indebtedness have been detected? A. Obtain written confirmation of indebtedness from the auditor of the affiliate. B. Send the standard bank confirmation request to all of the client's lender banks. C. Review client minutes and obtain a representation letter. D. Examine supporting documents for all entries in intercompany accounts.

Answer (C) is correct. The entity's auditor should review minutes of board of directors and relevant committee meetings and obtain a representation letter to obtain assurance that all guarantees of the affiliate's indebtedness have been identified.

Internal auditing can affect the scope of the external auditor's audit of financial statements by A. Limiting direct testing by the external auditor to assertions not directly tested by internal auditing. B. Eliminating the need to be on hand during the physical count of inventory. C. Decreasing the external auditor's need to perform detailed tests. D. Allowing the external auditor to limit his or her audit to substantive testing.

Answer (C) is correct. The work of the internal auditors may affect the nature, timing, and extent of the audit procedures, which include those for understanding internal control, assessing the risk of material misstatement, and performing substantive procedures.

46 Which of the following statements about an auditor's communication of internal control related matters identified in an audit of a nonissuer is true? A. Significant deficiencies or material weaknesses may not be communicated in a document that contains suggestions regarding activities that concern other topics such as business strategies or administrative efficiencies. B. The auditor may issue a written report to management and those charged with governance that no significant deficiencies were noted. C. The auditor should communicate significant internal control related matters no later than 60 days after the report release date. D. Significant deficiencies or material weaknesses need not be recommunicated each year if the audit committee has acknowledged its understanding of such deficiencies.

Answer (C) is correct. Timely communication of significant deficiencies or material weaknesses should be made no later than 60 days after the report release date. But the communication is best made by the report release date. However, early communication may be important because of the significance of the matters noted and the urgency of corrective action.

Which of the following circumstances most likely would require an auditor to apply an omitted procedure after the audit report issuance date? A. The engagement letter requires the procedure to be performed. B. The client has requested that the procedure be performed. C. The auditor's report is unsupported as a result of the omitted procedure. D. Generally accepted accounting principles are violated.

Answer (C) is correct. When the auditor decides that a necessary procedure was omitted, (s)he should assess its importance to his or her current ability to support the previously expressed opinion. The results of other procedures applied or audit evidence obtained in a later audit (possibly at an interim date) may compensate for an omitted procedure. The auditor may determine that the omission impairs his or her current ability to support the opinion. If (s)he believes persons are currently relying, or are likely to rely, on the report, the auditor should promptly apply the omitted procedure or alternative procedures that provide a satisfactory basis for the opinion.

Question: 91 Creditor Co. had a large account receivable that was considered fully collectible at its year end. However, the debtor's plant was destroyed during the subsequent events period. Because the debtor was uninsured, it is unlikely that the account will be paid. What is the effect of this event on the year-end statements? A. Adjustment of the financial statements. B. Disclosure by means of supplemental, pro forma financial data. C. No financial statement disclosure necessary. D. Disclosure in a note to the financial statements.

Answer (D) is correct. A debtor's major casualty subsequent to year end rendering a major receivable uncollectible is not indicative of conditions existing at the balance sheet date, so adjustment of (recognition in) the financial statements is not appropriate. But disclosure should be made to keep the statements from being misleading.

The primary reason an auditor requests letters of inquiry be sent to a client's legal counsel is to provide the auditor with A. Legal counsel's opinion of the client's historical experiences in recent similar litigation. B. The probable outcome of asserted claims and pending or threatened litigation. C. A description and evaluation of litigation, claims, and assessments that existed at the balance sheet date. D. Corroboration of the information furnished by management about litigation, claims, and assessments.

Answer (D) is correct. A letter of inquiry to a client's external legal counsel is the auditor's primary means of corroborating information furnished by management about litigation, claims, and assessments. If in-house legal counsel is primarily responsible for the entity's litigation, claims, and assessments, the auditor should send a similar letter of inquiry to in-house legal counsel. But the letter to in-house legal counsel is not a substitute for direct communication with external legal counsel.

Question: 93 An auditor has found that the notes to the financial statements do not mention that, 15 days after the balance sheet date, the company issued a substantial amount of debentures. According to the company's attorney, the debenture agreement restricts the payment of future cash dividends. The client has declined to include the matter of the debentures in the notes because the issuance occurred after the balance sheet date. The auditor should A. Add the note to the financial statements. B. Provide the missing information in the report and disclaim an opinion. C. Provide the missing information in the report and express an adverse opinion. D. Provide the missing information in the report and express a qualified opinion.

Answer (D) is correct. A subsequent event not providing evidence as to conditions existing at the balance sheet date does not result in adjustment of the statements. However, it may require disclosure to keep the statements from being misleading. The sale of a bond issue is an example of a subsequent event requiring disclosure but not adjustment. When such an event occurs between the report date and the date of the related financial statements, it should be disclosed in a note, or the auditor should modify the opinion.

51 Which of the following matters is an auditor required to communicate to those in the entity charged with governance? Disagreements with management about matters significant to the entity's financial statements that have been satisfactorily resolved Initial selection of significant accounting policies in emerging areas that lack authoritative guidance A. II only. B. Neither I nor II. C. I only. D. Both I and II.

Answer (D) is correct. AU-C 260, The Auditor's Communication with Those Charged with Governance, states that the matters to be discussed include (1) an overview of the planned scope and timing of the audit; (2) the auditors' responsibilities regarding the audit, such as performing the audit to obtain reasonable, not absolute, assurance about whether the statements are fairly presented; (3) significant accounting policies; (4) sensitive accounting estimates; (5) uncorrected and corrected misstatements; (6) the qualitative aspects of the entity's accounting practices; (7) significant difficulties during the audit; (8) auditor disagreements with management, whether or not satisfactorily resolved; and (9) any other findings and issues judged to be significant and relevant to those charged with governance. Under the Sarbanes-Oxley Act of 2002, a registered audit firm must communicate (1) critical accounting policies, (2) all alternative treatments of information within GAAP discussed with management, (3) the ramifications of using such treatments, and (4) the treatment preferred by the firm.

When a contingency is resolved immediately subsequent to the issuance of financial statements with a report that included a paragraph emphasizing the contingency, the auditor should A. Insist that the client issue revised financial statements. B. Inform the appropriate authorities that the report cannot be relied upon. C. Inform the audit committee that the report cannot be relied upon. D. Take no action regarding the event.

Answer (D) is correct. AU-C 560 states, "The auditor is not required to perform any audit procedures regarding the financial statements after the date of the auditor's report." But the auditor has responsibilities for subsequently discovered facts. The resolution of a contingency is not deemed to be a subsequently discovered fact for this purpose.

The primary source of information to be reported about litigation, claims, and assessments is the A. Independent auditor. B. Court records. C. Client's legal counsel. D. Client's management.

Answer (D) is correct. According to AU-C 501, "Management is responsible for adopting policies and procedures to identify, evaluate, and account for litigation, claims, and assessments as a basis for the preparation of financial statements in accordance with the requirements of the applicable financial reporting framework." The auditor should discuss with management its policies and procedures for identifying and evaluating these matters.

72 A client is a defendant in a patent infringement lawsuit against a major competitor. Which of the following items would least likely be included in legal counsel's response to the auditor's letter of inquiry? A. An evaluation of the probability of loss and a statement of the amount or range of loss if an unfavorable outcome is reasonably possible. B. A description of potential litigation in other matters unrelated to the patent infringement lawsuit. C. A discussion of case progress and the strategy currently in place by client management to resolve the lawsuit. D. An evaluation of the ability of the client to continue as a going concern if the verdict is unfavorable and maximum damages are awarded.

Answer (D) is correct. An inquiry letter response from the client's legal counsel will normally include information or comment about each pending or threatened litigation, claim, or assessment. Legal counsel should (1) address the progress of the case, (2) describe the action the company plans to take, (3) evaluate the likelihood of an unfavorable outcome, and (4) estimate (if possible) the range of any potential loss. Legal counsel does not have the expertise or appropriate information to make a judgment about the client's ability to continue as a going concern. The auditor normally makes that judgment.

55 Which of the following disagreements between the auditor and management do not have to be communicated by the auditor to those charged with governance? A. Disagreements about the scope of the audit. B. Disagreements regarding management's judgment about accounting estimates for goodwill. C. Disagreements in the application of accounting principles relating to software development costs. D. Disagreements of the amount of the LIFO inventory layer based on preliminary information.

Answer (D) is correct. Auditor disagreements with management about significant matters, whether or not satisfactorily resolved, should be communicated to those charged with governance. However, disagreements do not include differences of opinion based on preliminary information or incomplete facts that are later resolved.

Question: 92 Advertiser Co.'s directors voted immediately after year end to double the advertising budget for the coming year and authorized a change in advertising agencies. What is the effect of this event on the year-end statements? A. Disclosure in a note to the financial statements. B. Disclosure by means of supplemental, pro forma financial data. C. Adjustment of the financial statements. D. No financial statement revision.

Answer (D) is correct. Changing of budgets and other managerial decisions made by the directors or management are not significant subsequent events. Hence, no financial statement revision (disclosure or adjustment) is necessary.

What is the primary purpose of reviewing conflict-of-interest statements signed by members of management? A. To obtain an understanding of business processes. B. To consider limitations of internal control. C. To assess control risk. D. To identify transactions with related parties.

Answer (D) is correct. Conflict-of-interest statements obtained by the entity from its management are reviewed to identify material transactions with known related parties or indicate the existence of previously unknown related parties.

An auditor would be most likely to consider modifying an otherwise unmodified opinion if the client's financial statements include a note on related party transactions A. Disclosing compensating balance arrangements maintained for the benefit of related parties. B. Explaining the business purpose of the sale of real property to a related party. C. Presenting the dollar volume of related party transactions and the effects of any change in the method of establishing terms from that used in the prior period. D. Representing without substantiation that certain related party transactions were consummated on terms equivalent to those obtainable in transactions with unrelated parties.

Answer (D) is correct. It is most often not possible to determine whether a particular transaction would have occurred if the parties had not been related or what the terms and manner of settlement would have been. Accordingly, assertions about such matters are difficult to substantiate. The auditor may (1) believe that the assertion is unsubstantiated or (2) not be able to obtain sufficient appropriate evidence. In these cases, the auditor considers the implications for the audit, including whether to modify the opinion (AU-C 550 and AS 2410). (S)he should consider including in the report a comment to that effect and expressing a qualified or adverse opinion.

43 Which of the following issues related to internal control over financial reporting are required to be communicated in writing to management and those charged with governance? Deficiencies in internal control Significant deficiencies Material weaknesses A. None. B. III only. C. I, II, and III. D. II and III only.

Answer (D) is correct. Only those control deficiencies considered to be significant deficiencies or material weaknesses are required to be communicated in writing to management and those charged with governance. (But certain deficiencies should not be reported directly to management.) Other control deficiencies that merit management's attention should be reported to management orally or in writing. A deficiency in internal control exists when the design or operation of a control does not allow management or employees, in the normal course of their assigned functions, to prevent misstatements or detect and correct them on a timely basis. A significant deficiency is a deficiency, or combination of deficiencies, in internal control that is less severe than a material weakness but merits attention by those charged with governance. A material weakness is a deficiency, or combination of deficiencies, in internal control that results in a reasonable possibility that a material misstatement of the financial statements will not be prevented, or detected and corrected, on a timely basis. A reasonable possibility means that the probability of the event is more than remote.

Which of the following events most likely would indicate the existence of related party transactions? A. Making a loan with specific scheduled terms for repayment of the funds. B. Insuring the lives of key executives and listing the entity as beneficiary. C. Granting stock options to key executives at favorable prices. D. Selling real estate at a price that differs significantly from its appraised value.

Answer (D) is correct. Related party transactions may not be conducted in accordance with customary business practices. For example, in an arm's-length transaction, real estate with an appraised value usually is sold at approximately that value. A material disparity in the consideration exchanged may indicate that the parties are related.

78 An auditor is concerned with completing various phases of the audit after the balance sheet date. This subsequent period extends to the date of the A. Delivery of the auditor's report to the client. B. Final review of the audit documentation. C. Public issuance of the financial statements. D. Auditor's report.

Answer (D) is correct. Subsequent events procedures should be performed to cover the period from the date of the financial statements to the date of the auditor's report (or as near as practicable to it) (AU-C 560).

Which of the following best describes the responsibility of an auditor of a private entity with respect to significant deficiencies and material weaknesses under AU-C 265, Communication of Internal Control Related Matters Identified in an Audit? A. The auditor must exercise due diligence in searching for significant deficiencies and material weaknesses. B. The auditor's report is a general-use report and may be distributed to the shareholders. C. The auditor need not report the conditions if those charged with governance know of them. D. The communication by the auditor must be in writing.

Answer (D) is correct. The auditor communicates on a timely basis and in writing to those charged with governance significant deficiencies and material weaknesses identified during the audit. This communication includes those remediated during the audit. The auditor also communicates on a timely basis and in writing to the appropriate level of management significant deficiencies and material weaknesses communicated (or intended to be communicated) to those charged with governance. (But certain deficiencies should not be reported directly to management.)

On March 15, Year 2, Kent, CPA, expressed an unmodified opinion on a client's audited financial statements for the year ended December 31, Year 1. On May 4, Year 2, Kent's internal inspection program disclosed that engagement personnel failed to observe the client's physical inventory. Omission of this procedure impairs Kent's present ability to support the unmodified opinion. If the shareholders are currently relying on the opinion, Kent should first A. Advise management to disclose to the shareholders that Kent's unmodified opinion should not be relied on. B. Compensate for the omitted procedure by performing tests of controls to reduce audit risk to an acceptably low level. C. Reissue the auditor's report and add an additional paragraph describing the departure from generally accepted auditing standards. D. Undertake to apply alternative procedures that would provide a satisfactory basis for the unmodified opinion.

Answer (D) is correct. The auditor determines whether (1) the omission impairs his or her current ability to support the opinion, and (2) persons are currently relying or are likely to rely on the report. If these conditions currently exist, the auditor should promptly undertake to apply the omitted procedure or alternative procedures that would provide a satisfactory basis for the opinion (AU-C 585).

Question: 98 The auditor learned of the following situations after issuing the audit report on February 6. Each is important to users of the financial statements. For which one does the auditor have responsibility for disclosure of the newly discovered facts? A. A major lawsuit against the company, which was the basis for a modified report, was settled on unfavorable terms on March 1. B. On February 16, a fire destroyed the principal manufacturing plant. C. The client undertook merger negotiations on March 16 and concluded a merger agreement on April 1. D. A conflict of interest involving credit officers and a principal company supplier that existed during the audit year was discovered on March 3.

Answer (D) is correct. The auditor has a responsibility after the date of the report for events that come to his or her attention that may have caused revision of the report. A conflict of interest situation would have been examined by the auditor had (s)he known about it during the audit.

An auditor referred to the findings of an auditor's external specialist in the auditor's report. This may be an appropriate reporting practice if the A. Auditor is not familiar with the professional certification, personal reputation, or particular competence of the specialist. B. Auditor, as a result of the specialist's findings, adds a paragraph emphasizing a matter regarding the financial statements. C. Auditor, as a result of the specialist's findings, decides to indicate a division of responsibility with the specialist for the audit opinion. D. Auditor's report contains a qualified opinion.

Answer (D) is correct. The auditor refers to the work of an auditor's external specialist because it is relevant to a modification of the opinion. In these circumstances, the report should indicate that the reference does not reduce the auditor's responsibility for the opinion. If the auditor's report contains an unmodified opinion, the auditor should not refer to the work of an auditor's specialist (AU-C 620). A modified opinion is a qualified opinion, an adverse opinion, or a disclaimer of opinion (AU-C 705).

An auditor searching for related party transactions should obtain an understanding of each subsidiary's relationship to the total entity because A. Interentity transactions may have been consummated on terms equivalent to arm's-length transactions. B. This may reveal whether particular transactions would have taken place if the parties had not been related. C. This may permit the audit of interentity account balances to be performed as of concurrent dates. D. The business structure may be deliberately designed to obscure related party transactions.

Answer (D) is correct. The nature of related party relationships and transactions may result in greater risks of material misstatement than transactions with unrelated parties. Thus, related parties may operate through a complex set of relationships and structures, with increased complexity of related party transactions. For example, a transaction may involve multiple related parties in a consolidated group. Accordingly, in an audit of group statements, the group engagement team should request each component auditor to communicate with related parties not previously identified by group management or the group engagement team.

77 Which of the following procedures can be performed only after the date of the financial statements? A. Reading of the minutes of the board of directors' meetings. B. Tests of the details of balances. C. Tests of the details of transactions. D. Examination of data to determine that a proper cutoff has been made.

Answer (D) is correct. The objective of a cutoff test is to determine that transactions are reported in the correct period. A cutoff test can be performed only after year end when all transactions for the year can be identified.

Question: 95 Under which of the following circumstances may audited financial statements contain a note that is labeled "unaudited," disclosing an event occurring after the balance sheet date? A. When audit procedures with respect to the event were not performed by the auditor. B. When the subsequent event requires adjustment of the financial statements. C. When the event occurs after the date of the related financial statements. D. When the event occurs after the date of the auditor's original report.

Answer (D) is correct. To prevent the financial statements from being misleading, management may disclose an event that arose after the date of the auditor's report. If the event is included in a separate note labeled as unaudited [e.g., a note captioned as "Event (Unaudited) Subsequent to the Date of the Independent Auditor's Report"], the auditor need not perform any procedures on the note. Moreover, the auditor's report should have the same date as the original report (AU-C 560).

Question: 90 Which of the following material events occurring subsequent to the December 31, Year 1, balance sheet date will not ordinarily result in an adjustment of the financial statements before they are issued on March 2, Year 2? A. Settlement of extended litigation on January 23, Year 2, in excess of the recorded year-end liability. B. A 3-for-5 reverse stock split consummated on January 23, Year 2. C. Write-off of a receivable from a debtor who had suffered from a deteriorating financial condition for the past 6 years. The debtor filed for bankruptcy on January 23, Year 2. D. Acquisition of a subsidiary on January 23, Year 2. Negotiations had begun in December of Year 1.

Answer (D) is correct. Under U.S. GAAP, an entity recognizes in the financial statements the effects of all subsequent events that provide additional evidence about conditions existing at the balance sheet date. The acquisition of the subsidiary did not occur until after year end. Thus, the purchase required at most disclosure, not adjustment of (recognition in) the statements.

Question: 99 Subsequent to the date of the auditor's report, the auditor became aware of facts existing at the report date that would have affected the report had the auditor then been aware of such facts. The auditor should A. Issue revised pro forma financial statements taking into consideration the newly discovered information. B. Notify the board of directors that the auditor's report must no longer be associated with the financial statements. C. Request that management disclose the effects of the newly discovered information by adding a note to subsequently issued financial statements. D. Determine whether the financial statements need revision.

Answer (D) is correct. When new information that existed at the report date has been discovered, the auditor should (1) discuss the matter with management and, when appropriate, those charged with governance and (2) determine whether the financial statements need revision and, if so, inquire how management intends to address the matter in the financial statements.

Which of the following steps should an auditor perform first to determine the existence of related parties? A. Review proxy and other materials filed with the SEC. B. Review the company's business structure. C. Examine invoices, contracts, and purchasing orders. D. Inquire about the existence of related parties from management.

Answer (D) is correct. When obtaining an understanding of the entity's related party relationships and transactions, the auditor should inquire of management regarding (1) the identity of the entity's related parties, including changes from the prior period; (2) the relationships of the entity with those parties; and (3) the types and purposes of transactions with them.

Zero Corp. suffered a loss having a material effect on its financial statements as a result of a customer's bankruptcy that rendered a trade receivable uncollectible. This bankruptcy occurred suddenly because of a natural disaster 10 days after Zero's balance sheet date but 1 month before the issuance of the financial statements and the auditor's report. Under these circumstances, the Financial statements should be adjusted Y/N Event Requires Financial statement disclosure, but no adjustment y/n Auditor's report should be modified for a lack of consistency y/n

No Yes No

For which of the following judgments may an independent auditor share responsibility with an entity's internal auditor who is assessed to be both competent and objective? Materiality of Misstatements Yes/No Evaluation of Significant Accounting Estimates Yes/No

No No

In an audit engagement, should an auditor communicate the following matters to those charged with governance? Auditors judgments about the quality of the client's accounting principles Y/N Issues discussed with management prior to the auditor's retention Y/N

YY

During an audit, an internal auditor may provide direct assistance to an independent CPA in Obtaining an Understanding of Internal Control Y/N Performing Tests of Controls Y/N Performing Substantive Tests Y/N

YYY